In accrual accounting, revenues and expenses are reported in the period when transactions occur, regardless of whether payment has been received. While this practice may seem strange at first, many Americans use it everyday without thinking about it. Consider credit cards. Whenever someone uses a credit card, there is no cash changing hands, only an understanding that if everything runs smoothly, the purchaser will pay their credit card company who in turn will reimburse the seller. This is a form of accrual accounting.
Another form of accrual accounting is accounts receivable. When retailers sell products on credit (think of the countless advertisements offering "no money down, no payments until the next year"), this is an example of accounts receivable. In this case, a retailer agrees to accept payments over time in exchange for a good or service. For example, if a shopper were to purchase a $1,000 television on credit from TV Shack, there would be an agreement that they would pay the store back in monthly payments until the full $1,000 is paid off. This $1,000 to be paid off in time would be considered accounts receivable.
The store is able to report the $1,000 sale in the current period even though it will not be receiving payment until a later date. The net realizable value, in this case $1,000, is what the store will receive back from the customer if the customer pays his debts according to the agreement. It reports that it has made a $1,000 sale, based on the assumption that it will be receiving the cash eventually. But what if the customer is unable to pay back the loan on time? What if the customer is unable to pay back the debt in full? Or at all? This would mean that the $1,000 revenue that was reported by the company was never realized. In other words, the company is out $1,000 that it told investors that it had. This phenomenon is known as bad debt.
Businesses know that in some cases they will not recoup what they have lent, but rather than abandon lending, these firms take precautions against bad debt. In some cases, businesses will only lend to the most qualified buyers. In others, the businesses simply demand a larger down payment and charge a higher rate of interest to less qualified buyers. Anyone who has purchased a home is familiar with these strategies that businesses take to insulate themselves from defaults. Many have heard of subprime mortgages, fewer know that this is simply an example of offering mortgages with higher interest rates to buyers who are more likely to default. These are simply methods that companies use to improve their chances of getting their loans paid back.
Another method businesses use to hedge bad loans is a bad debts expense. Also known as an uncollectible debt expense, firms are able to calculate with some degree of accuracy the amount of money that they will need to set aside in case some of their loans are not repaid. In some cases, firms simply assume that a given percent of their loans will default and set aside this percentage of their total loans. In others, the businesses keep track of which loans are most likely to default in order to determine their bad debts expense. This money that is set aside is known as the loan loss reserve.
There is some concern that companies' loan loss reserves are inadequate in the face of an economic downturn. Using the percentage model noted earlier, these firms only keep a fraction of the money that they have lent out on hand in case of defaults. This is not unlike the fractional reserve system that our banks use. And like a run on a bank, if for some reason enough of the debtors default on their loans, the company may not have enough money to write off these expenses. Because of this vulnerability, there is a concern that many companies are not as healthy as they may appear.
Recall from above the example where TV Shack lent someone $1,000 to buy a television on credit and then reported $1,000 profit before the customer had begun to pay it off. This may be fine in good economic times, and the customer will likely be able to pay off his debt. But if the economy declines, the customer may not be able to pay the debt because of unforeseen circumstances. TV Shack feels the impact of this as well because they do not get all or any of their $1,000. Because of this, TV Shack is weaker than it looks on paper. TV Shack's investors were unintentionally misled when they read TV Shack's statements reporting $1,000 profit that will never come. For this reason there is concern that the current methods for dealing with bad debt in accrual accounting are inadequate.
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